How Equally-Weighted Funds Work

Equally weighted funds attract investors' attention because a number of them are well-known as market beaters. Over the last 10 years, the returns of funds like Guggenheim S&P 500 Equal Weight ETFhave beaten the standard S&P 500 index fund by about 0.50% per year, despite having higher fees than ordinary index funds.

But the reason for their out-performance may not be as complex as you might think. In fact, much of it can be attributed to the funds' higher-than-average risks.

In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss the differences between equally weighted funds and classic market-cap weighted funds.

A full transcript follows the video.

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This podcast was recorded on March 20, 2017.

Gaby Lapera: Our first question comes from Rob. He writes, "Recently, I have been reading about equal weight index funds as compared to the standard capital weighted funds." Example: RSP(NYSEMKT: RSP) vs. SPY(NYSEMKT: SPY). "Can you explore these equal-weight funds in depth, please?" So, why don't we start with explaining what the difference is between those two types of funds.

Jordan Wathen: I think the big difference is that -- there's really two differences, but one of the big ones is the standard is market cap weighted, as he alluded to, which means that the largest companies make up the largest part of the index. So, for something like the S&P 500, the largest holdings, in order, are Apple, Microsoft, and Johnson & Johnson. Three out of 500 companies, those three, make about 8% of the S&P 500.

Lapera: That's incredible.

Wathen: If you look at an equally weighted index, it means that all of those are treated equally. So, those three, instead of making up 8% of the index, would make up 0.6% of the index.

Lapera: That makes sense. That would mean that in equal weighted funds, smaller cap companies make up a larger percentage of the companies represented.

Wathen: Right. If you look at it, you would say the big difference between them is that the market cap weighted funds, the standard funds, are biased toward the largest stocks, whereas equally weighted funds are more biased toward the smaller stocks. In a traditional S&P 500 funds, the standard fund, it invests about 45% of its assets in giant companies, or, super-large-cap companies. An equally weighted fund would only have about 12% of its assets in those companies. So, you can see, an equally weighted fund is way less reliant on the big 10 or 20 companies that make up the index.

Lapera: Yeah, and I'm sure there's pros and cons to each.

Wathen: A standard S&P fund, the second big difference between these two is the industry difference. As I said before, the two largest components of the S&P 500 are Apple and Microsoft, two huge tech giants. If you look at an equally weighted index, tech only makes up about 12% of assets. But in a standard S&P 500, it makes up about 18% of assets. So, there's a size difference, and there's also the industry difference between the two funds.

Lapera: Yeah. So, maybe if you're looking to be really heavily invested in tech and big companies, the standard market cap weighted one might be for you. But if you're looking to be a little bit more diverse in your interests, maybe be equally weighted one is for you.

Wathen: Right. I think what gets people interested in this is that over long spans of periods of time, the equally weighted one will probably outperform because it has exposure to small and mid-cap companies, which typically outperform larger caps. But, obviously, that outperformance comes with more volatility. You're going to have to deal with greater losses in a year where the S&P 500 is down.

Lapera: Yeah. And the reason that the small and mid-caps tend to outperform the large caps over the long term is because the small and mid-caps have room to grow, whereas the super-long mega-giant-caps that make up a lot of the market cap weighted ones don't have as much space to grow, so it's getting harder and harder for them to outperform their performance from last year.

Wathen: Just look at Apple, for example. If you look at Apple, by assets, a lot of it is just cash. And obviously, cash isn't going to beat stocks in the long haul. So, intuitively, it makes sense that a lot of these largest companies that derive a lot of their value from earnings years ago aren't going to outperform the companies that will outperform on the basis of earnings going forward.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple and Johnson and Johnson. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.